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Small cap biotech investments with upcoming FDA catalysts have become one of the hottest new trends, especially due to the fact that it is easy to foresee or expect catalysts based on the use of FDA calendars and general medical timelines on drug and clinical trials. Unlike other industries where new technologies in research and development are usually kept secret in order to deter competition, the biotech game is wide open as companies publicize their products from the very beginning all the way to marketing approval. This is because biotechs usually need on average $50-75 million dollars from an investigational new drug status all the way to completing phase I, II, and III trials and then into marketing. They thus look to maximize their market caps earlier on based on hype in order to fund projects through share offerings.

While many investors have become wealthy from multi-bagger gains by holding onto companies into PDUFA decisions, the grass isn’t always greener on the other side. Such an example was witnessed on February, 1, 2011, where investors of Orexigen (NASDAQ:OREX) got burned by following highly bullish analyst reports and an FDA panel vote which basically spelled out approval as a cake-walk. To the surprise of many investors, shares dropped 75% in the pre-market once a complete response letter declining marketing approval was received. Interestingly enough, Protalix (NYSEMKT:PLX) seems to be following the same path as Orexigen. This is especially apparent when taking a look at the dramatic increase in Protalix’s share price leading up to the FDA decision scheduled for February 25, 2011, while taking into consideration short interest, technical analysis and insider transactions.

There is perhaps no better variable for predicting a company’s future outlook than the vote of confidence from one’s own management gives through either the purchase or selling of shares. For many investors, both small and large, insider transactions via SEC forms has become almost like a magic 8 ball — providing guidance, more often than not correctly, almost like shining a light into the direction of the company. Despite this, it has become easy to get trapped in reading reports by mainstream media which concentrate on upcoming, potentially positive, FDA catalysts, often ignoring red flags such as high short interest, poor looking technicals, and insider transactions.

Orexigen’s Fate Through The Eyes Of Insiders and Short Interest

Such a circumstance was seen most recently with shares of Orexigen which saw its shares explode upwards from $4.50 all the way to a 52-week high of $11.15 almost overnight on a positive FDA panel vote. This paved the way for what seemed to be a riskless investment into their February 1st PDUFA. Most investors made their choice by going long and investing in the company based on upbeat analyst reports flaunting their product potentials while ignoring one of the most important variables; insider selling.

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According to the SEC Form 4 website, there were 7 transactions during 2010 on the open market, all of which consisted of selling shares. These combined for a grand total of 2,961,254 being sold, or nearly 11% of the total float which consists of 24.93M.

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Another important aspect to consider was that short interest had dropped significantly leading up to the PDUFA, whether that was due to the highly positive sentiment of the FDA panel vote, or simply institutions flirting with options profits remains a conspiracy at best. When investors or institutions short a stock, they are essentially borrowing shares from a brokerage house in order to sell them in the hope that they can buy them later (or cover) at a lower price, return the shares to their owner, and profit on the difference. The key provision in this agreement is that a short seller has to buy back the stock.

As you will notice when looking at Protalix, it seems the company is following the doomed footsteps of Orexigen in an almost mirror-like fashion.

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Amazingly, Protalix has matched Orexigen in insider selling from the SEC Form 4 website almost to the point, with 5,800,952 or 9.7% of the total float outstanding. All of this came from 9 transactions during 2010, of which all were sales consisting of the CFO, VPs, and Executive VP.

If this isn’t enough to make your stomach turn, perhaps the short interest also directly mimicking that of Orexigen will.

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Taking a look at the short interest during December and January, we noticed an almost identical pattern to that of Orexigen.

Using Put Options To Your Advantage

So now that we’ve established that Protalix is holding Orexigen’s hand going into its PDUFA, how can we use the past failure in order to learn and profit from? A nice and simple answer comes to mind — buying put options with low premiums that could double or triple our investments.

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While Orexigen’s failures made headlines across some of the world’s biggest investment publications, causing many investors to lose there shirts, there where those who followed the subtle signs and profited by going against the crowd and playing the contrarian role. Taking a look at the chart for Orexigen options, for example, buying the $7 put strike option with February 18 expiration prior to the PDUFA would have netted you a cool 270% gain overnight, while minimizing your risk of a small loss should it have received approval due to the fact the stock’s share price already ran up significantly prior.

Such is the situation with Protalix which is up 50% during the last 6 months on speculation of approval, and much like Orexigen, paves the way for quite a nasty drop towards the 52-week low of $5.63 should a negative complete response letter also meet its fate. Much like its counterpart, Protalix’s put options offer a high risk, high reward scenario, and a smart choice would be the March 18 expiration $7.50 strike put options, which currently trades at a premium of $0.85, and could double or triple from here if history repeats itself.

In conclusion, through the eyes of a devil’s advocate, Protalix is receiving the hype, positive expert medical opinions and analysis the same way Orexigen did, all the while being accompanied by insider selling and a repeated pattern of short interest, which may or may not draw a similar outcome.

Disclosure: Short PLX via March Puts

Source: Insider Selling and Options Trading May Spell Troubles for Protalix